Chapter 8yamamoto/files/Jun_8-2.pdf · ©2005 Pearson Education, Inc. Chapter 8 2 Topics to be...

Chapter 8

Profit Maximization andCompetitive Supply

Chapter 8 2©2005 Pearson Education, Inc.

Topics to be Discussed

�Perfectly Competitive Markets

�Profit Maximization

�Marginal Revenue, Marginal Cost, andProfit Maximization

�Choosing Output in the Short Run


Topics to be Discussed

� The Competitive Firm’s Short-RunSupply Curve

�Short-Run Market Supply

�Choosing Output in the Long Run

� The Industry’s Long-Run Supply Curve


Perfectly Competitive Markets

� The model of perfect competition can beused to study a variety of markets

� Basic assumptions of PerfectlyCompetitive Markets

1. Price taking

2. Product homogeneity

3. Free entry and exit



1. Price Taking� The individual firm sells a very small share

of the total market output and, therefore,cannot influence market price

� Each firm takes market price as given –price taker

� The individual consumer buys too small ashare of industry output to have any impacton market price



2. Product Homogeneity� The products of all firms are perfect

substitutes� Product quality is relatively similar as well

as other product characteristics� Agricultural products, oil, copper, iron,

lumber� Heterogeneous products, such as brand

names, can charge higher prices becausethey are perceived as better



3. Free Entry and Exit� When there are no special costs that make

it difficult for a firm to enter (or exit) anindustry

� Buyers can easily switch from one supplierto another

� Suppliers can easily enter or exit a market� Pharmaceutical companies are not perfectly

competitive because of the large costs of R&Drequired


When are Markets Competitive?

� Few real products are perfectlycompetitive

�Many markets are, however, highlycompetitive�They face relatively low entry and exit costs�Highly elastic demand curves

�No rule of thumb to determine whether amarket is close to perfectly competitive�Depends on how they behave in situations


Profit Maximization

�Do firms maximize profits?�Managers in firms may be concerned with

other objectives� Revenue maximization

� Revenue growth

� Dividend maximization

� Short-run profit maximization (due to bonus orpromotion incentive)

� Could be at expense of long run profits


Profit Maximization

� Implications of non-profit objective�Over the long run, investors would not

support the company

�Without profits, survival is unlikely incompetitive industries

�Managers have constrained freedom topursue goals other than long-run profitmaximization


Marginal Revenue, MarginalCost, and Profit Maximization

�We can study profit maximizing output forany firm, whether perfectly competitive ornot�Profit (π) = Total Revenue - Total Cost

�If q is output of the firm, then total revenue isprice of the good times quantity

�Total Revenue (R) = Pq



�Costs of production depends on output�Total Cost (C) = C(q)

�Profit for the firm, π, is differencebetween revenue and costs

)()()( qCqRq −=π



� Firm selects output to maximize thedifference between revenue and cost

�We can graph the total revenue and totalcost curves to show maximizing profitsfor the firm

�Distance between revenues and costsshow profits



� Revenue is a curve, showing that a firm canonly sell more if it lowers its price

� Slope of the revenue curve is the marginalrevenue�Change in revenue resulting from a one-unit increase

in output

� Slope of the total cost curve is marginal cost�Additional cost of producing an additional unit of

output



� If the producer tries to raise price, sales arezero

� Profit is negative to begin with, since revenue isnot large enough to cover fixed and variablecosts

� As output rises, revenue rises faster than costsincreasing profit

� Profit increases until it is maxed at q*� Profit is maximized where MR = MC or where

slopes of the R(q) and C(q) curves are equal


Profit Maximization – Short Run

0

Cost,Revenue,

Profit($s per

year)

Output

C(q)

R(q)A

B

π(q)q0 q*

Profits are maximized where MR (slopeat A) and MC (slope at B) are equal

Profits aremaximizedwhere R(q) –C(q) ismaximized



�Profit is maximized at the point at whichan additional increment to output leavesprofit unchanged

MCMR

MCMR

q

C

q

R

q

CR

=

=−=

=Δ

Δ−

Δ

Δ=

Δ

Δ

−=

0

0π

π



� The Competitive Firm�Price taker – market price and output

determined from total market demand andsupply

�Market output (Q) and firm output (q)

�Market demand (D) and firm demand (d)


The Competitive Firm

�Demand curve faced by an individual firmis a horizontal line�Firm’s sales have no effect on market price

�Demand curve faced by whole market isdownward sloping�Shows amount of goods all consumers will

purchase at different prices



d$4

Output (bushels)

Price$ per bushel

100 200

Firm Industry

D

$4

S

Price$ per bushel

Output (millions of bushels)

100



� The competitive firm’s demand�Individual producer sells all units for $4

regardless of that producer’s level of output

�MR = P with the horizontal demand curve

�For a perfectly competitive firm, profitmaximizing output occurs when

ARPMRqMC ===)(


Choosing Output: Short Run

�We will combine revenue and costs withdemand to determine profit maximizingoutput decisions

� In the short run, capital is fixed and firmmust choose levels of variable inputs tomaximize profits

�We can look at the graph of MR, MC,ATC and AVC to determine profits


Choosing Output: Short Run

� The point where MR = MC, the profitmaximizing output is chosen�MR = MC at quantity, q*, of 8

�At a quantity less than 8, MR > MC, so moreprofit can be gained by increasing output

�At a quantity greater than 8, MC > MR,increasing output will decrease profits


q2

A Competitive Firm

10

20

30

40

Price

50

MC

AVC

ATC

0 1 2 3 4 5 6 7 8 9 10 11Outputq*

AR=MR=PA

q1 : MR > MCq2: MC > MRq*: MC = MR

q1

Lost Profitfor q2>q*Lost Profit

for q2>q*

Chapter 8yamamoto/files/Jun_8-2.pdf · ©2005 Pearson Education, Inc. Chapter 8 2 Topics to be...

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